Partner Article

The dangers of crowd funding

Since recession took hold, lending to small businesses has reduced significantly; and so enter, crowd-funding or peer-to peer-lending which threatens to fill this void, writes Mark Sisson, managing director at 4most Europe.

From the borrower perspective, there are a string of benefits to be had; speed of decision in the lending process, choice of investment so owners feel their investors are genuine endorsers of their business idea; and of course you have the spread of invested funds across multiple opportunities so individual failures have an insignificant effect on return.

What could possibly go wrong? I’ll tell you.

Lack of robust data analysis

While the quality of accepted loans sourced via crowd-funding has typically been good in the past, it’s likely that as the market grows, a more diverse set of applicants will use this route to gain funding. Simultaneously investors will become more willing to move down the risk curve in search of higher returns.

That in itself is fine; however, growing larger and more diverse requires a significant improvement in the quality of the analysis available to investors.

Credit risk is not child’s play and pricing correctly for the long term has taxed experts’ minds and has yielded only limited success. These loans are provided to individuals and small companies that differ widely in their ability to repay and how they might react in an economic downturn.

Large financial institutions can treat pools of loans as a commodity but only with the backing of robust and comprehensive data and analysis. Sloppy underwriting and inaccurate information can quickly catch even relatively large well-capitalised investors out.

When is a good idea not a good idea?

The other danger of crowd funding is that business ideas that would ordinarily fail the rigour and scrutiny of the traditional bank loan would nevertheless gain funding approval through less-rigorous channels, whether they are particularly good or innovative ideas or not, resulting in a market akin to the dotcom boom in the late nineties. One has to question if you you can’t convince educated, savvy backers to invest in a business perhaps the idea isn’t so good after-all?

Investor check-list

Would-be investors need to mitigate the risk of total loss via:

1. Publishing detailed tracking information. This should include expected and measured performance of risk grades for similar assets lent to in the past as well as the performance of the debt collection function on debts that have defaulted.
2. Providing the underlying anonymised facility level data so independent parties can verify that performance and check model assumptions
3. Providing a flexible online tool to make it easy for prospective investors to understand the potential losses of their portfolio under different stressed economic conditions.

Closing this information gap would be a big step forward in countering potential regulatory concerns of the downsides of crowd-funding that are not fully apparent to investors.

The BIG investor question

In conclusion, the key question for investors is - do crowd-funding and peer-to-peer lending sites offer better returns because they cut out the middle man and provide a more efficient market, or are the improved returns a financial slight of hand borne out of regulatory arbitrage that hides risk in the system? At present the answer is both – until crowd-funders can demonstrate the same rigour as their regulated cousins in banks then they don’t yet deserve to be a mass-market phenomenon.

This was posted in Bdaily's Members' News section by 4most Europe .